Exchange rate in currency market refers to that rate at which the currency of the country can be bought and sold by various parties like importers, exporters, banks, individuals and so on. Exchange rate are of two types that is fixed and floating exchange, given below are the differences between the fixed and floating exchange rates –
- Under fixed exchange rate system the exchange rate of the currency remains fixed whereas under floating exchange rate system the exchange rate of the currency keeps fluctuating.
- Fixed exchange rate system requires constant intervention from the government so that currency does not fluctuate and the exchange rate remains fixed whereas under floating exchange rate system there is no or minimal intervention from the government and there is free movement of the exchange rate.
- Under fixed exchange rate government needs to have enough foreign exchange reserves so that it can sell those foreign exchange reserves for local currency and save the local currency from deprecating against foreign currency whereas under floating exchange rate government does not require substantial amount of foreign exchange as currency exchange rate is determined by demand and supply and therefore no need to buy or sell foreign exchange reserves.
- Fixed exchange rate does not truly reflect the correct value of the currency against other currencies because of constant government intervention while floating exchange rate reflects true value of currency because when market are allowed to function freely they discover the true value by taking into account the demand and supply of the asset class (in this case it is currency). Hence if a country is growing quickly then its currency will appreciate against other currencies and if country economy is facing a downturn then its currency will depreciate against other currencies.
As one can see from the above that there are many differences between fixed and floating exchange rate, however in real life majority of the countries use of mix of both system because if currencies are completely left to markets then it can lead to problem if there is too much speculation on currency and therefore government intervention is necessary to keep speculation in check.